The Shakeout In Financials May Have Set The Sector Up For Success

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(Tuesday Market Open) After Monday’s close, social media company Snap (SNAP) lowered its second-quarter earnings and revenue expectations due to the rapidly slowing economy. The stock plunged nearly 30% in extended-hours trading, taking other social media stocks and the equity index futures with it.

Potential Market Movers

This morning, Snap is still down more than 29% and S&P 500 futures are down nearly 1%. Looking at some of the other social media stocks in premarket action, Meta (NASDAQ: FB) was down 7%, Alphabet (NASDAQ: GOOGL) fell 4.69%, Pinterest PINS had fallen 12%, Twitter (NYSE: TWTR) dropped 3.5%, and Etsy ETSY tumbled more than 2%.

However, bearishness early Tuesday morning wasn’t just in social media. It moved into several retailers filing fresh earnings reports.

Abercrombie & Fitch ANF fell more than 21% in premarket trading after reporting an unexpected loss and lowering its sales growth forecast to 7%.
Best Buy BBY was able to meet analysts’ earnings estimates and spiked 8% in premarket action before giving back gains and turning negative by nearly 2.5%.
Ralph Lauren RL beat on top- and bottom-line numbers but offered single-digit revenue growth guidance for its fiscal 2023. The stock jumped on the news but surrendered much of its gains before the opening bell.
AutoZone AZO also jumped after topping earnings and revenue estimates but pulled back to a gain of just 0.82% before the opening bell.
Chewy CHWY fell 1.81% after Barclay’s lowered its price target for the stock but maintained its Equal Weight rating.

Not all earnings reactions were so negative. Chinese gaming and multimedia company NetEase NTES beat on earnings and revenue, prompting a rally of 4.29% in premarket action. Zoom Video ZM is up about 4% in premarket action after beating on top- and bottom-line numbers.

The food inflation picture is getting worse as food supplies are facing new pressures with export bans in reaction to the Russia-Ukraine war on top of heat waves, droughts, poor harvests, and continuing supply chain bottlenecks. According to Bloomberg, India is expected to announce plans to restrict exports on sugar, joining countries like Russia, Algeria, Kosovo, and Ukraine. A week ago, India banned foreign wheat sales due to shortages from Russia and Ukraine. Meanwhile, the BBC reported that Malaysia is expected to halt chicken exports starting June 1 while Argentina is banning beef exports. Indonesia has blocked exports of palm oil, Argentina has blocked soybean oil, and Russia and Ukraine are restricting sunflower oil.

Reviewing the Market Minutes

Financials got a shot in the arm on Monday at JPMorgan Chase (JPM)’s annual Investor Day. The nation’s largest bank said it may reach its goal of 17% return on tangible equity this year. JPM added that its annual run rate of net interest income could reach $66 billion by the fourth quarter if the Federal Reserve boosts its short-term rate to 3% by year-end. The company’s stock rallied 6.19% on the news.

JPMorgan CEO Jamie Dimon told investors that the economy is still fundamentally strong and the “storm clouds may dissipate.” However, he acknowledged that Russia-Ukraine war, higher inflation, and Fed tightening still pose risk for the markets.

JPM’s positive news reverberated through the banking sector, causing the PHLX KBW Bank Index (BKX) to rally 4.08% on the news. Bank of America (BAC) shot up 5.94% while Wells Fargo (WFC) gained 5.16%.

The financials sector led the market, followed by energy and consumer staples as every sector finished the day in the green. A weaker U.S. dollar ($DXY) helped large multinational stocks as the S&P 500 (SPX) rose 1.86%, the Dow Jones Industrial Average ($DJI) climbed 1.98%, and the Nasdaq Composite ($COMP) increased 1.59%. Investor chose stocks over bonds, causing bond prices to fall and the 10-year Treasury yield (TNX) to rise 72 basis points.

Briefing.com said part of the reason for Monday’s rally was that the month’s declines in stocks and gains in the bond market required some rebalancing at the end of the month. With the Memorial Day holiday coming up, some money managers needed to sell bonds and buy equities to maintain their portfolio risk profile a little earlier than normal so they could fire up the grill over the weekend. Stock purchases were broad with the Russell 3000 Value Index (RAV) and the Russell 3000 Growth Index (RAG) rising 1.5% apiece.

However, analysts from Citigroup C were busy issuing downgrades on several retail stocks. The list looked like a mall directory with names like Abercrombie & Fitch ANF, American Eagle AEO, Carter’s CRI, Gap GPS, Kohl’s KSS, Ralph Lauren RL, The Children’s Place PLCE and Under Armour UAA. Most downgrades went from buy to neutral or neutral to sell. Despite the downgrades, the Dow Jones U.S. Retail Index rose 0.83%.

In merger Monday news, VMWare VMW rallied 25.3% on reports that Broadcom AVGO plans to acquire VMW in a cash-and-stock deal.

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CHART OF THE DAY: BANKING ON IT. The PHLX Bank Index (BKX—candlesticks) has underperformed the S&P 500 (SPX—pink) and the Financials Select Sector Index ($IXM—blue) over the last year. However recently, the BKX has demonstrated some relative strength (green) against the S&P 500. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Three Things to Watch

Rising Cost of Raises: Around the first of the year, the large banks took off as yields rose, commonly leading to a wider bank spread that translates into greater profitability. However, Q4 2021 earnings turned out to be a tough time for the banks as the labor shortage drove rising labor costs and continual turnover among personnel.

In 2021, Goldman Sachs GS saw its compensation costs jump 33%. Citigroup’s C compensation also rose 33% in the fourth quarter year-to-year while JPMorgan Chase JPM recorded a 14% increase. On Monday, the American Banker reported that Bank of America BAC is planning to raise its minimum wage to $22 an hour starting in July and is forecasting the base wage of $25 by 2025.

Take it to the Banks: In addition to labor costs, rising yields hit investment banking hard, though they helped conventional banking. Suddenly, 2021’s hot IPO market cooled down quickly in 2022 as deal calendars emptied and trading revenues started to shrink. Today, investment banking and trading revenues are now closer to their pre-pandemic levels.

While rising labor costs will continue to be a risk for banks, contraction on the investment banking side of the business may have finally put banks and other financials in a position to benefit from rising yields, making the bank spread a larger driver of profitability.

Revolving Credit: If banks can attract attention and mount a comeback, it could be good news for the rest of the market. Traditionally, banks are a leading sector during an economic recovery, which is why investors who follow sector rotation will often keep an eye on financials when trying to pick a market bottom.

However, there are still a plenty of risks for financials to overcome like rising labor costs, inflation, an increasingly unaffordable housing market, and declining consumer sentiment just for a start. Additionally, as JPMorgan warned on Monday, the gains in the bank spread are dependent upon the Fed raising rates to 3% by the end of the year.

Also, The Wall Street Journal reported last week that banks are feeling the pinch of auto loan delinquencies from subprime borrowers. And earlier this month, MarketWatch reported that mortgage delinquencies rose for the first time in nine months during April and the U.S. foreclosure rate jumped 541% from a year ago when homeowners were protected by Washington’s pandemic-era foreclosure freeze.